Curbing Corporate Debt Bias

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Summary:

Tax provisions favoring corporate debt over equity finance (“debt bias”) are widely recognized
as a risk to financial stability. This paper explores whether and how thin-capitalization rules,
which restrict interest deductibility beyond a certain amount, affect corporate debt ratios and
mitigate financial stability risk. We find that rules targeted at related party borrowing (the
majority of today’s rules) have no significant impact on debt bias—which relates to third-party
borrowing. Also, these rules have no effect on broader indicators of firm financial distress.
Rules applying to all debt, in contrast, turn out to be effective: the presence of such a rule
reduces the debt-asset ratio in an average company by 5 percentage points; and they reduce
the probability for a firm to be in financial distress by 5 percent. Debt ratios are found to be
more responsive to thin capitalization rules in industries characterized by a high share of
tangible assets.